Willis - Bankruptcy Court Rules Individual IRAs not Exempt in Bankruptcy 

By Barry C. Picker, CPA/PFS, CFP®

EXECUTIVE SUMMARY

A bankruptcy court in Florida has ruled that an individual's IRAs are not exempt from the claims of creditors due to the individual’s transactions with the IRA.

FACTS

Ernest W. Willis filed for bankruptcy under Chapter 7 of the Bankruptcy Code on February 16, 2007. He claimed exemptions pursuant to11 U.S.C. Sec 522(b)(3)(C) of three individual retirement accounts. One account was a Merrill Lynch account valued at $1,247,000. A second account was held at AmTrust Bank and was valued at $109,000. A third IRA was a Fidelity Federal IRA valued at $143,000. The bankruptcy trustee and Red Reef, Inc., a creditor, objected to the claimed exemptions of the three IRA accounts. The trustee later withdrew her objection to the claimed exemption in the AmTrust and Fidelity IRA accounts.

The Merrill Lynch IRA Custodial Agreement was a standard prototype that had been approved by the IRS. The IRS stated in its approval that this determination was to the form, and not the merit, of the Merrill Lynch IRA. The Merrill Lynch IRA Agreement noted that taxpayers were prohibited from engaging in certain transactions, and that engaging in such prohibited transactions would cause the IRA to lose its tax-deferred status. The Merrill Lynch IRA Agreement also stated that the IRA was ‘self directed’, meaning that the taxpayer was responsible for managing the investments in the account.

The objections to the claimed exemptions of the IRA accounts are based on Mr. Willis' conduct with respect to the Merrill Lynch IRA. Specifically there were two occasions when it was alleged that Mr. Willis used IRA funds for personal purposes in violation of the Internal Revenue Code section 4975, which deals with prohibited transactions in an IRA.

The first occasion occurred in 1993. Mr. and Mrs. Willis owned a 50% interest in a company called Ocean One North Inc. (Ocean One) which owned a piece of improved real estate in Florida. Ocean One was delinquent in its mortgage obligation to People Southwest Limited Real Estate Partnership (Southwest). In December 1993 Mr. Willis and Southwest entered into an agreement in which Mr. Willis would purchase the mortgage held by Southwest. In order to fund this purchase Mr. Willis withdrew $700,000 from the Merrill Lynch IRA on or about December 20, 1993. This money was transferred to Southwest and Southwest executed an assignment of mortgage naming Mr. Willis as the assignee.

On or about February 22, 1994, 64 days after the December 20, 1993 date, Mr. Willis returned $700,000 to the Merrill Lynch IRA.

At trial Mr. Willis was asked, "so what you did was you borrowed $700,000 from your IRA in order to go ahead and acquire that mortgage and note from People's Southwest that was owed by Ocean One North, Inc.; isn't that true?". Mr. Willis replied, "yes, I withdrew the money."

The second occasion involving the Merrill Lynch IRA occurred in 1997. At that time due to a sudden decline in Mr. Willis' brokerage account, he engaged in what appeared to be a check swapping process between his brokerage account and the Merrill Lynch IRA. In his deposition, Mr. Willis testified that through this process, he also attempted to avoid taxation on the Merrill Lynch IRA withdrawals by returning funds to the Merrill Lynch IRA within 60 days. He did this by simultaneously transferring funds from his IRA account to his brokerage account while at the same time transferring funds from his brokerage account to his IRA. There was a total of eight transfers back and forth.

As a result of the transfers, Mr. Willis made total deposits of $2,022,000 into his brokerage account, and total deposits of $1,835,000 into his IRA account. The net result was a positive increase of $186,500 in the brokerage account.

In discussing the AmTrust Bank IRA it was determined that this IRA resulted from a series of IRA rollovers that was initiated by a transfer of Merrill Lynch IRA funds.

As to the Fidelity Federal IRA, $50,000 was transferred from the Merrill Lynch IRA on or about August 16, 2002 and $10,000 was transferred from the Merrill Lynch IRA on or about November 8, 2002.

Mr. Willis' claims of exemption of the three IRA accounts is pursuant to 11 U.S.C. Sec. 522(b)(3)(C). This section provides an exemption of "retirement fund to the extent that those funds are in a fund or account that is exempt from taxation under section 401 403, 408, 408A, 414, 457, or 501(a) of the Internal Revenue Code of 1986."

11 U.S.C. Sections 522(b)(4)(A) and (B) provide two different analyses to determine whether an IRA qualifies for exempt status. Section 522(b)(4)(A) applies when an IRA has received an IRS favorable determination under section 7805 of the Internal Revenue Code, and Sections 522(b)(4)(B) applies when an IRA has not. In this case there is no question that the Merrill Lynch IRA had received a favorable determination.

Since there was nothing in the record to indicate that the other two IRAs had not received a favorable IRS determination, the Court presumed that they had received a favorable determination from the IRS.

Therefore, in order to determine whether the IRAs are exempt, Section 522(b)(4)(A) is the operative section.

That section states, "if the retirement funds are in a retirement fund that has received a favorable determination under section 7805 of the Internal Revenue Code of 1986, and that determination is in effect as of the date of the filing of the petition in a case under this title, those funds shall be presumed to be exempt from the estate." (Italics added).

This case then turned on the question of the definition of the word "presumed".

Mr. Willis argued that the presumption of exemption was irrebuttable.

The Court then went into a discussion of the definition of the word "presume" using the Black's Law Dictionary: "to assume beforehand; to suppose to be true in the absence of proof."

The Court stated that a bankruptcy court's decision regarding a retirement plan's qualified status was not limited by any previous IRS determination as to a plan's qualified status, and an IRS determination is based upon the plan's structure, and not its actual operation.

Mr. Willis cited the case McGowan v. Ries, 226 B.R. 13 (B.A.P. 8th Cir. 1998) in arguing that the language in Section 522(b)(4)(A) create an irrebuttable presumption. The court however pointed out that the McGowan case did not deal with the word "presume", but rather with the word "deemed" and concluded that that word, "deemed", created a conclusive presumption and not a rebuttable presumption. However, the operative word in this case is “presumed”, not “deemed”.

Mr. Willis further argued that Congress intended to restrict the bankruptcy courts’ discretion with relation to IRAs and to give deference to the IRS. The Court pointed out, however, that deference to the IRS’ determination as to the form of the IRA is not relevant when the Court is determining the operations of the IRA.

The Court thus concluded that while an IRS favorable determination created a presumption that the IRA funds were exempt from the bankruptcy estate, that presumption is rebuttable. Therefore, the parties may present evidence to establish that the IRA was improperly operated under the applicable provisions of the Internal Revenue Code which would disqualify the IRA funds from exempt status.

In order to rebut this presumption, the trustee and creditor argued that Mr. Willis was a disqualified person with respect to his IRA, and that he had engaged in prohibited transactions.

Sec. 408(e)(1) of the Internal Revenue Code provides in part that: Any individual retirement account is exempt from taxation under this subtitle unless such account has ceased to be an individual retirement account by reason of paragraph (2) or (3).

Sec. 408(e)(2) provides in part that: If, during any taxable year of the individual for whose benefit any individual retirement account is established, that individual or his beneficiary engages in any transaction prohibited by section 4975 with respect to such account, such account ceases to be an individual retirement account as of the first day of such taxable year. For the purposes of this paragraph - (i) the individual for whose benefit any account was established is treated as a creator of such account, and (ii) the separate account for any individual within an individual retirement account maintained by an employer or association of employees is treated as a separate individual retirement account. (emphasis added).

Sec. 4975 of the Internal Revenue Code defines prohibited transactions thus: For purposes of this section, the term “prohibited transaction” means any direct or indirect - (A) sale or exchange, or leasing, of any property between a plan and a disqualified person; (B) lending of money or other extension of credit between a plan and a disqualified person; (C) furnishing of goods, services, or facilities between a plan and a disqualified person: (D) transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan; (E) act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interest or for his own account; or (F) receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.

The Trustee and creditor contend that Mr. Willis engaged in three prohibited transactions. First, that he borrowed money from the Merrill Lynch IRA to acquire the Ocean One mortgage from Southwest. Second, that he borrowed money from the Merrill Lynch IRA in order to engage in the 1997 check swapping which covered the shortfall in the brokerage account. Third, that Ocean One borrowed money from the Merrill Lynch IRA in order to acquire the Ocean One mortgage from Southwest.

The Court dismissed the third claim as unproved, but then discussed the validity of the first two claims.

Since a prohibited transaction involves a disqualified person, the Court first had to determine if Mr. Willis was a disqualified person. The Court looked to the Sec. 4975 definitions of disqualified persons, and determined that the definition of ‘fiduciary’ fit Mr. Willis, since he exercised discretionary authority with respect to the management of the account, and the disposition of the IRA assets, including the ability to transfer funds into and out of the account without obstruction.

Having determined that Mr. Willis was a disqualified person, the next question was whether he engaged in any prohibited transactions.

The Court looked first to the 1993 transfer of $700,000 from the Merrill Lynch IRA to Mr. Willis personally, which was used to acquire the Ocean One mortgage from Southwest. The Court relied on Sec. 4975(c)(1)(D) which states that any direct or indirect transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan constitutes a prohibited transaction. Mr. Willis’ purchase of the mortgage from Southwest allowed Mr. Willis to later sell the property for $1.2 million. The Court concluded that the 1993 transfer to Mr. Willis was a transfer for his benefit, and thus a prohibited transaction. Therefore, concluded the Court, the Merrill Lynch IRA ceased to be an IRA as of the beginning of 1993.

After having made this determination due to the transfer of the $700,000, the Court determined that Mr. Willis also engaged in a prohibited transaction in 1993 under Sec. 4975 (c)(1)(B) by borrowing the $700,000 in December, 1993 and returning it 64 days later in February, 2004. Once again, the Court concluded that the Merrill Lynch IRA ceased to be a valid IRA account as of the beginning of 1993.

Looking next to the 1997 check swapping scheme, the Court concluded that this also constituted prohibited borrowing from the Merrill Lynch IRA, and that the IRA would have ceased to be a valid IRA as of the beginning of 1997, if it had not already ceased to be a valid IRA as of the beginning of 1993.

Having shown the Mr. Willis engaged in prohibited transactions causing the Merrill Lynch IRA to cease being a valid IRA account going back to 1993, the Court concluded that the Trustee and creditor met their burden of proof in rebutting the presumption created by the IRS favorable determination. Accordingly, the Merrill Lynch IRA was not an exempt asset under 11 U.S.C. Sec. 522 (b)(3)(C).

With regards to the AmTrust and Fidelity Federal IRA accounts, the Court reviewed evidence as to the tracing of funds in these IRA accounts back to the non exempt Merrill Lynch IRA. To the extent that it was shown that funds in these IRAs came from the Merrill Lynch IRA, these accounts were also ruled to be non exempt assets.

Thus concluded the Court, the Merrill Lynch IRA in the amount of $1,247,000, the AmTrust Bank IRA in the amount of $109,000, and $60,000 of the Fidelity Federal IRA, were not exempt assets under 11 U.S.C. Sec. 522 (b)(3)(C).

COMMENT

This case shows some interesting interactions between the Bankruptcy Code and the Internal Revenue Code (IRC).

Looking first to the 1993 transaction, Mr. Willis withdrew $700,000 and returned it to the IRA 64 days later. If the IRS had been aware of this, this most likely would have been considered an illegal rollover contribution in 1994, as a violation of the 60 day rollover rule. The tax result would be that the $700,000 was taxable income in 1993 and the $700,000 deposit in February, 1994 would be an illegal contribution, subject to a 6% excise tax each year until withdrawn. It is highly unlikely that the IRS would turn this into a prohibited transaction, in my opinion. Had the funds been returned within the 60 day rollover period, I don’t see how it could be then deemed a prohibited transaction, since the Internal Revenue Code can’t prohibit what it explicitly permits. One is left to wonder if Mr. Willis’ counsel had argued invalid rollover, whether that could have saved at least part of the Merrill Lynch IRA. Of course, this is moot due to the 1997 check swapping, which depending on your point of view was either a prohibited transaction in 1997, or a total withdrawal of the IRA funds since the redeposits were illegal due to the one per year rule on 60 day rollovers. In either event, the Merrill Lynch IRA would be kaput in 1997, if it had not already been so ruled as of 1993.

Due to the statute of limitations on income tax returns, it is likely that the IRS will never get the tax dollars on Mr. Willis’ IRAs. But then again, Mr. Willis no longer has these IRAs.

Despite the Bankruptcy Code’s exemptions for IRAs and retirement accounts, creditors will sniff around for any excuse to convince the Court that accounts have lost their exempt status. In this case, the creditor was able to go back 14 years prior to the filing to find the bad behavior.

It is critical that any individual with retirement accounts that is going through a bankruptcy, have clean hands with regards to all dealings with their retirement account.

Since one does not know the future, one needs to always have clean hands with regards to their dealings with their retirement accounts.

This case shows two things – in asking “how will the IRS find out”, the answer is they may not.

But the second thing is, if in bankruptcy, no tax statute of limitations rule will keep the funds from the creditors.

HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE!

CITES

In re: Ernest W. Willis, Debtor. Case No.: 07-11010-BKC-PGH